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The 1031 Exchange Real Estate Tax Deferral Most People Don't Use

Despite the changing economy, real estate remains one of the most reliable ways to build wealth. The downside to that is, the more wealth you create, the more taxes you usually have to pay. For many, finding legal ways to lower taxes is an ongoing hunt. Surprisingly, the government has given active real estate investors a straightforward—and legal—way to defer capital gains tax on real estate transactions. Many seasoned investors don’t use it. Why not? For the most part, it may be because many people aren’t aware of it.

What is the 1031 Exchange Tax Deferral?

If you’ve never taken the time to read through the IRS Tax Code (who can blame you?), you may not know about this deferred tax provision. If you don’t yet use a tax professional for your real estate business, you wouldn’t have anyone else telling you about it, either. It’s there in black and white, in Section 1031 of the Tax Code.

The 1031 exchange tax deferral allows real estate investors to defer taxes by selling and then buying more properties within a specific time frame, and which fall into certain categories. In a traditional real estate transaction, you might buy a property, wait for its value to appreciate, then sell it at a profit. You’d then pay taxes on the profit. Those taxes can really take a bite out of your profit; plus they reduce the amount of money you have to invest in another piece of property. This can really hold you back as far as wealth building.

With the 1031 exchange, you buy and sell a property as usual, but instead of paying taxes on the profit, you defer taxes by following the next steps and rules set up in the tax code. The rules include:

  • Hold the property for about a year to demonstrate your investment objective.
  • Identify between one and three properties to buy within 45 days of selling the old property
  • Close on the new property within 180 days of selling the old property
  • The new property has to be a like-kind property, such as a single family home and a single family home, or an apartment building and an apartment building.
  • Buy and sell properties in one name only.
  • Never take personal possession of the funds at any point in the transaction (use an intermediary to facilitate this).

These rules might seem complicated at first read, but they are very straightforward. The only ambiguity may stem from knowing specifically how long to hold a particular property before you can sell it and still defer taxes. As is the case with most real estate transactions, it’s best to hire a tax professional to assist you.

As long as you follow the guidelines, the buy, sell, buy transactions qualify as a 1031 exchange and you can defer taxes on the sale. In fact, you can keep doing this as many times as you want during your lifetime. When you pass on, your heirs won’t have to pay taxes on those sales, either. If they sell your current property, they only pay tax on the current market value. Essentially, this gives you perpetual deferred taxes!

Would you like to learn more about how to use the 1031 exchange in combination with a passive real estate investment model? Contact us today to speak to a representative.